Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 16334

IMPLEMENTATION COMPLETION REPORT

UKRAINE

REHABILITATION LOAN

3831-UA

February 27, 1997

Country Operations Division IICountry Department IVEurope and Central Asia Region

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

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CURRENCY EOUIVALENTS(as of February 28, 1997)

Currency Unit HrivnyaUS$1 Hrivnya 1.765

WEIGHTS AND MEASURESMetric System

ABBREVIATIONS AND ACRONYMS

IBRD - International Bank for Reconstruction and DevelopmentIDA - International Development AssociationPIU - Project Implementation UnitSOE - Statement of Expenditures

MOF - Ministry of Finance

AGSECAL - Agriculture Sector Adjustment LoanCG - Consultative Group

EDAL - Enterprise Development Adjustment LoanFSU - Former Soviet Union

GDP - Gross Domestic Product

ICR - Implementation Completion ReportIMF - International Monetary Fund

NBU - National Bank of UkraineSTF - Systemic Transformation Facility

VER - Voluntary Export Restraint

UKRAINE'S FISCAL YEAR

January I - December 31

Vice President: Johannes Linn, ECAVPDirector: Basil Kavalsky, EC4DR

Division Chief: Wafik Grais, EC4C2Responsible Staff: Chandrashekar Pant, Consultant, Ritu Anand, Senior Economist, EC4C2

FOR OFFICIAL USE ONLY

IMPLEMENTATION COMPLETION REPORT

UKRAINE

REHABILITATION LOAN 3831-UA

ContentsPreface ....................................................................... i

Evaluation Summary ...................................................................... ii

Part I. Project Implementation Assessment ....................................................................... 1

Part II. Statistical Tables ...................................................................... 12

TABLE 1: SUMMARY OF ASSESSMENTS ............................................................................... 13 -14TAbLE 2: RELATED BANK LOANS/CREDITS .............................................................................. 15TABLE 3: PROJECT TIMETABLE .............................................................................. 16TABLE 4: LOAN/CREDIT DISBURSEMENTS: CUMULATIVE ESTIMATED AND ACTUAL ....................................... 17TABLE 5: KEY INDICATORS FOR PROJECT IMPLEMENTATION ...................................................................... 18-21TABLE 6: KEY INDICATORS FOR PROJECT OPERATION .............................................................................. 22TABLE 7: STUDIES INCLUDED IN PROJECT .............................................................................. 23TABLE 8A: PROJECT COSTS .............................................................................. 24TABLE 8B: PROJECT FINANCING .............................................................................. 25TABLE 9: ECONOMIC COSTS AND BENEFITS .............................................................................. 26TABLE 10: STATUS OF LEGAL COVENANTS .............................................................................. 27TABLE I 1: COMPLIANCE WITH OPERATIONAL MANUAL STATEMENTS ............................................................. 28TABLE 12: BANK RESOURCES: STAFF INPUTS .............................................................................. 29TABLE 13: BANK RESOURCES: MISSIONS .............................................................................. 30

Appendixes:A. Borrower contribution to the ICR ...................................................................... 31-33B. Map

Vice President: Johannes Linn, ECAVPDirector: Basil Kavalsky, EC4DR

Division Chief: Wafik Grais, EC4C2Responsible Staff: Chandrashekar Pant, Consultant, Ritu Anand, Senior Economist, EC4C2

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

IMPLEMENTATION COMPLETION REPORT

UKRAINE

REHABILITATION LOAN 3831-UA

Preface

This is the Implementation Completion Report (ICR) for the Rehabilitation Loan in Ukraine, forwhich Loan No. 3831-UA in the amount of US$500 million equivalent was approved on December 22,1994 and made effective on December 27, 1994.

The loan closed on June 30, 1996, the original closing date. The first part of the disbursements,which was made available upon effectiveness was fully disbursed by April, 1996. The second part ($250million) was released on May 15, 1996. The loan was fully disbursed on May 31, 1996. Co-financingfor the project was provided by the Canadian Government for US$10 million and the Export-ImportBank of Japan for US$150 million.

The ICR was prepared by Chandrashekar Pant, Consultant for the Country Operations DivisionII of the Europe and Central Asia Region, and reviewed by Wafik Grais, Division Chief, EC4C2, andMs. Judy O'Connor, Principal Operations Officer, EC4DR. The borrower provided comments that areincluded as appendixes to the ICR.

The ICR was prepared as a desk task in the second half of 1996. It is based on material in theproject file. The borrower contributed to the preparation of the ICR by preparing its own evaluation ofthe project's execution.

IMPLEMENTATION COMPLETION REPORT

UKRAINE

REHABILITATION LOAN 3831-UA

Evaluation Summary

Introduction

1. The Rehabilitation Loan was preceded by the Institutional Building Loan ($27 million) approvedby the Board in June 1993. Following years of macro-economic instability and economic mis-management, in mid-1994 newly elected President Kuchma indicated his firm commitment tomacroeconomic stability and systemic reforms. The Rehabilitation Loan supported his efforts. Sincethen, the Bank has approved 10 projects, including the Hydropower Rehabilitation and System ControlProject ($114 million) approved in April 1995, the Agricultural Seed Development Project ($32 million)approved in May 1995, a Pilot Project in the Coal Sector ($15.8 million) and a Housing Project ($17million) approved in May 1996, the Enterprise Development Adjustment Loan (EDAL, $310 million)approved in June 1996, a small Social Protection Support Project ($2.6 million), approved in September1996, an Electricity Market Development Loan ($317 million) and an Agriculture Sector AdjustmentLoan (AGSECAL, $300 million) approved in October 1996, an Export Development Loan ($70 million)approved in November 1996, and a Coal Sector Adjustment Loan ($300 million) approved in December1996. The Bank's economic and sector work has included a Country Economic Memorandum (1993),and sector reviews in Agriculture, Transport, Energy, Environment, Finance, Housing, and the socialsectors. A poverty assessment was completed in June 1996.

Project Objectives

2. The main goals were to significantly lower the rate of inflation, to stop the decline in economicactivity and to create a market-oriented, private sector-led economy. Funds from the Loan were alsomeant to alleviate the severe shortage of energy in the winter of 1994-95 and to strengthen the socialsafety net. The Bank's loan also provided a framework for financial assistance from other donoragencies. The goals were appropriate, but too ambitious.

Implementation Experience and Results

3. The results of the project were mixed. On the positive side, the loan financed critically neededenergy imports, alleviating the harsh winter conditions. The budget had more resources to strengthen thesocial safety net. The Rehabilitation Loan also provided a framework for mobilizing the internationalfinancial community in support of Ukraine's efforts. Through the CG process which the Bank chaired,the Loan prompted the international community to pledge $ 5.5 billion in economic assistance, debtrescheduling, and arrears consolidation to meet Ukraine's 1995 balance of payments financingrequirements. By its timely support to Ukraine's reform efforts, and the additional resources mobilizedthrough the CG process, the Rehabilitation Loan strengthened the position of the reformers within thegovernment, and enhanced their ability to carry them forward. Two years down the road, this may beone of its biggest achievements.

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4. The project was less successful in other respects. First, macro-economic performance waserratic. Though the rate of inflation came down from an average of 16 percent per month in 1994 toabout 5 percent in December 1995, this was much more than the targeted rate of 1-2 percent per month.Economic activity fell 13 percent in 1995, considerably more than the 5 percent projected by the Bank.And Ukraine could not prevent a further accumulation of external payment arrears. Partial success wasachieved in liberalizing the economy and reducing the role of the state. Compared to the past, thedomestic pricing and foreign trade regimes are considerably liberal today, though the state continues tointervene more than it should. After many false starts, privatization was finally initiated but the pace wasvery slow for most of 1995 (paras. 12-21).

5. Deep divisions continued to exist within the government and outside (notably in Parliament) onthe need for reforms and their pace, which constrained their implementation. Reforms were also sloweddown by institutional constraints and unfamiliarity with the way markets function. Poor weather and lessthan expected external financing also contributed to slower than projected economic recovery (paras.22-25).

6. While the Rehabilitation Loan addressed key issues and policies, there were some aspects in thedesign that were not fully thought through. For example, closing down a few large enterprises andrequiring restructuring plans to be drawn up were insufficient to improve financial discipline. Moreattention should have been devoted to addressing the issue of arrears in the energy sector.

7. Objectives and indicative targets of the reform program supported by the Loan were often toooptimistic. To some extent, targets were deliberately ambitious to exhort greater effort. But it alsoreflected an inadequate appreciation of the continuing opposition to reforms. Institutional constraintswhich slowed down implementation were not adequately recognized.

8. The reform process remains uncomfortably fragile, and can be reversed. To prevent this, thegovernment must attempt, even more determinedly than before, to continue the course of reforms it hasinitiated. Rapid privatization of industry and agriculture, and strict enforcement of financial disciplineand accountability in state enterprises are essential. And payment issues in the energy sector need to beaddressed urgently as they could quickly undermine Ukraine's external creditworthiness. Theinternational community must continue to actively support these efforts of the government.

Summary of Findings, Future Operations, and Key Lessons Learned

9. The results were more than satisfactory when compared to the economic situation existing at thetime the loan was approved. The rate of inflation was lowered, and the rate of decline in GDP wasslowed down. The economy was considerably liberalized and privatization was initiated. However, byand large, the outcomes fell short of expectations, and the reform process remains fragile and by nomeans irreversible.

10. Follow-up operations carry forward the reforms initiated under the Rehabilitation Loan. In June1996, the EDAL was approved which accelerates privatization of small and large enterprises, andsupports the growth of the capital market and post-privatization restructuring of enterprises. An

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Agriculture Sector Adjustment Loan was approved in October 1996 that seeks to accelerate land reformsand private sector development. The Electricity Market Development Loan aims to hasten thedevelopment of a competitive wholesale market for electricity. And the Coal Sector Adjustment Loanfacilitates efficient restructuring in the coal sector. Other operations planned for the near future includea Pre-Export Guarantee Facility, Urban Transport Project, and a Legal Reform Loan. Follow upadjustment operations are proposed to support reforms in the public sector and in the financial sector.

11. The main lessons from the project are as follows:

(i) There is a strong tendency in the Bank to be over-optimistic about the outcomes ofadjustment operations, both in terms of macroeconomic objectives (reduction in inflation, growth ofGDP and exports) as well as structural changes (extent of privatization, demonopolization).

(ii) The opposition to market reforms is deeply entrenched. The Bank needs to decidewhether there is sufficient commitment within the country to warrant its continued involvement inreform efforts and then to stay engaged despite slippage and temporary reversals, which are inevitable.In practical terms, this requires identifying some key signposts that indicate the government'scommitment to reforms (such as macroeconomic stability and privatization) and to continue to supportthe government as long as these signs point in the right direction.

(iii) To the extent possible, the Bank should seek to involve in policy discussions those ingovernment who are skeptical about the reforms, especially when they pertain to agriculture and thesocial sectors. This may be time-consuming and difficult, but ultimately beneficial.

(iv) Institutional capacity is limited, and very little can be done in the short time frame of anadjustment loan to change this. The Rehabilitation Loan had to be comprehensive in coverage becausemajor distortions were everywhere and addressing one of them without the other would have failed. Butsubsequent operations should as far as possible be more narrowly focused. In this context the emphasison sector adjustment loans is appropriate. The Bank should continue to assist the government indeveloping its capacity to design and manage reforms, recognizing there is no quick and easy fix.

(v) The most difficult reforms to implement, and the most important, are those that seek toenforce financial discipline in enterprises and farms, and make them more responsive to market forces.Apart from privatization in industry and agriculture, phasing out of budget transfers and credit subsidiesto specific sectors and enterprises, prevention of accumulation of payment and tax arrears, and measuresto facilitate new entrants and the closure of unviable firms are especially important. Adjustment in theenergy sector is especially urgent as payment arrears threaten Ukraine's external creditworthiness.

(vi) There is often a tendency to do something more about enterprises that will notimmediately be privatized. Typically, this takes the form of closing down a few large unviableenterprises and requiring restructuring plans to be developed for selected enterprises. However, there islittle evidence suggesting these measures have contributed to any lasting solution. Unless there is a veryclear concept behind these kinds of interventions, and a long term commitment from the Bank to remainclosely involved in these efforts, they should be avoided.

(vii) Policy conditionality should be designed to be as 'close' as possible to the specificobjective that is to be achieved. Thus for example, conditions such as "presentation of draft law toParliament .." should be avoided because (a) legislation may not be really required (as in the case of

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procedures for land registration in Ukraine) and (b) there is a big gap between presentation of law and itsapproval by Parliament, let alone the implementation of the policy.

(viii) Given the uncertain political support for reforms, the limited institutional capacity andthe uncertainties of predicting the nature and size of supply response, it would be prudent to maintainrealistic expectations and to be flexible in our response to slippages in policy and projected outcomes.The phased disbursement design of the Ukraine Rehabilitation Loan was a useful innovation in thisregard.

(ix) Intensive monitoring and supervision by the Government and the Bank is essentialduring the early years of reform when slippages may occur not just because there is active opposition butmerely because of misunderstanding about what needed to be done or insufficient manpower. Anadequately staffed Bank Resident Mission can play an invaluable role in this respect.

(x) A suitably empowered authority in the Government to coordinate and oversee progressin reforms is vital not only for the internalization of the reform program, but also to preventimplementation of sectoral policies that go against the spirit of the economy-wide reforms.

IMPLEMENTATION COMPLETION REPORT

UKRAINE

REHABILITATION LOAN 3831-UA

Part I. Project Implementation Assessment

A. PROJECT OBJECTIVES

1. Economic conditions in Ukraine were worsening when the government initiated economicreforms which were supported by the Rehabilitation Loan. The rate of inflation had touchedhyperinflationary levels by the last quarter of 1993. Real GDP was estimated to have declined by 27percent in the first half of 1994, following a cumulative decline of 38 percent during 1990-93. Realwages had fallen by more than 60 percent in 1993 and had not recovered. And with the accumulation ofhuge payment arrears with Russia and Turkmenistan, Ukraine was finding it increasingly difficult to payfor critically needed energy imports.

2. In late 1994, under the leadership of the newly elected President Mr. Kuchma, Ukraine embarkedon a comprehensive program of macroeconomic stabilization and market-oriented economic reforms.The main objectives were to reduce the rate of inflation, to stop the decline in economic activity and tocreate a market- oriented, private sector- led economy. The World Bank's Rehabilitation Loan (for $500million) supported these objectives. Funds from the Loan were also meant to alleviate the severeshortage of energy in the winter months, and to help pay for strengthening the social safety net. Togetherwith the IMF's Systemic Transformation Facility (STF), the Bank's loan sought to provide a frameworkfor financial assistance from other donors.

3. Given the sorry state of Ukraine's economy, there was no question about the objectives. Norwas there much doubt about what needed to be done. Loose financial policies had played havoc withmacro-economic balances, and there was general agreement that a tightening of financial policies wasnecessary to reduce the rate of inflation and improve the balance of payments. State interventions werepervasive and were stifling entrepreneurship, forcing an increasing share of the economy undergroundand capital abroad. Freeing the shackles from the private sector and progressively increasing the role ofmarkets was necessary in order to stem the economic decline and improve productivity. Thus the loansupported the de-regulation of prices and the foreign exchange and trade regimes; privatization anddemonopolization in agriculture and industry; and measures to strengthen the social safety net. In theshort term, the loan financed the most critical and obvious needs; energy imports were badly required toalleviate the harsh winter conditions, and budgetary support for strengthening the safety net was essentialnot only on humanitarian grounds but also to maintain public support for structural reforms.

4. While the objectives and the direction of reforms were clear, there is no doubt that they wereambitious, maybe unrealistically so. Partly, this reflects a basic dilemma faced by the Bank in othercountries of the region as well. On the one hand, the depth of the economic crisis and the magnitude andpervasiveness of the distortions in the economy necessitates a wide-ranging program of macro-economicstabilization and structural reforms. Piece-meal measures are not likely to work. On the other hand, theinadequate institutional capacity makes it very difficult to implement market reforms across a wide front.

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The Bank has typically favored going for the comprehensive approach, knowing well that some of thetargets may not be achieved and that further adjustments in the objectives and program may be requiredas capacity or other constraints are faced. This was also the approach in this project (See section C).The reforms were ambitious in another important respect. It was clear that the consensus in favor ofreforms was at best fragile. While the main counterparts in government were committed to the reformprogram, a large section of government and population did not understand it, nor were in favor. The riskthis posed to implementation was recognized, but it was felt that opposition could only be overcomegradually by the demonstrable results of the reforms (lowering of inflation, stopping the decline ineconomic activity).

B. ACHIEVEMENT OF PROGRAM OBJECTIVES

5. The results of the reform program thus far and the loan are mixed. On the positive side, theproceeds of the loan helped finance critically needed energy imports and alleviated the harsh winterconditions. In addition to the funds directly made available by the Bank through this loan, the JapaneseGovernment cofinanced the loan for $150 million and the Canadian Government provided an additional$10 million. The support lent to the reform program by the Bank and the IMF was also instrumental inattracting other external donors to Ukraine's cause. Overall, through the CG process which the Bankchaired, the international community pledged $5.5 billion in economic assistance, debt rescheduling, andarrears consolidation to meet Ukraine's 1995 balance of payments financing requirements.

6. The reform program was less successful in other respects. First, macro-economic performancewas erratic through 1995 and early 1996. Though the rate of inflation came down considerablycompared to the pre-reform days, (from an average of 16 percent per month in 1994 to about 5 percentin December 1995), this was much more than the targeted rate of 1-2 percent per month. Moreover,progress was uneven. Inflation remained stubbornly high in late 1994-early 1995, then slowed down tomonthly rates of about 5 percent by the middle of 1995, before rising to almost 14 percent in September1995. Monthly inflation fell to about 5 percent in November and December before rising to more than 9percent in January 1996. While some of these increases were attributable to increases in administeredprices, nevertheless the underlying rate of inflation exceeded program targets. It is only since the springof 1996 that the rate has been down consistently to around 2 percent monthly.

7. Economic activity also fell more than projected in 1995. Real GDP is estimated to have fallenby 13 percent in 1995 compared to the Bank's estimate of 5 percentl This may have been due to anumber of factors, including partial and inconsistent implementation of reforms (see Section C andAppendix 1), less than anticipated foreign financing, and exogenous factors (such as the droughtaffecting agricultural output in 1995). Thus while industrial production was hurt by the break-down ofthe state order system, the slow pace of privatization, weak financial discipline and continuingrestrictions on trade hampered a market-based positive supply response. Price volatility and otheruncertainties in the policy environment also contributed to dampening producer and investor confidencethroughout 1995.

8. The strong growth of exports to Western countries in 1995 (20 percent in volume) was aremarkable achievement. However, the balance of payments remained severely strained and Ukraine

The real decline in economic activity may have been less than what these numbers indicate due to the growth of theunderground economy.

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continued to accumulate external payment arrears (mainly on account of gas payments to Russia andTurkmenistan) in 1995. These arrears reflected weak payment discipline by the government, householdsand enterprises within Ukraine, and insufficient real adjustment in the energy sector in particular.

9. An important objective of the reform program supported by the Loan was to increase the role ofmarkets and the private sector and reduce the interventionist role of the state in resource mobilizationand allocation. In this respect, important gains were made, though once again progress was much slowerthan expected (for a summary evaluation see section below; for more details about specificcommitments, see Appendix 1). Compared to the past, the domestic pricing and foreign trade regimesare considerably more liberal, though the state continues to intervene more than it should. After manyfalse starts, privatization was finally initiated but the pace was slow for most of 1995. It has picked upsince.

10. The Loan was a rapid response from the Bank to Ukraine's financial crisis. By providing timelyfinancial assistance, and mobilizing the international community to support Ukraine's reform program, ithelped shore-up the credibility of the few reformers in government at the time, and strengthened theircapacity to carry the reforms forward. Their task would certainly have been more difficult had thissupport not been forthcoming as quickly as it did. This is arguably the Loan's most importantachievement.

11. Another achievement was that the Loan opened up a sweeping agenda for reforms, including inparticular in crucial sectors, such as energy and agriculture. Important issues were identified and firststeps in reforms were taken. Subsequent operations (such as the EDAL, sector operations in power andcoal, and the AGSECAL) seek to deepen these reforms and carry them forward.

C. IMPLEMENTATION RECORD

12. As mentioned above, the record of implementation of macro-economic policies and structuralreforms was mixed. Notable successes were achieved, and a definitive break was made from pastpolicies towards establishing a market-based economy. However, reforms have been slower andshallower than expected.

13. Macroeconomic stabilization: A critical component of the stabilization effort was thecontainment of the budget deficit. Despite the revenue losses stemming from major tax reforms, as wellas the general weakening of economic activity, the overall fiscal adjustment during 1995 was good. Thecash deficit for 1995 was around 4 percent of GDP, less than half of the 8.6 percent recorded in 1994, butmore than the 3.3 percent targeted at the beginning of the year. The slippage was largely due to over-runs in expenditures, reflecting larger than planned wage increases to government employees, subsidiesto the coal mining sector, and the payment of arrears on gas imports. The larger budget deficit and theless than expected financing from external sources resulted in a larger than targeted volume of bankingsystem credit to the budget.

14. Monetary policy was tuned to reduce the inflation rate to 1-2 percent per month by the end of1995 and to replenish international reserves. However, broad money expanded more rapidly thanprogrammed, mostly due to larger than expected capital inflows in the second and third quarters of 1995.The National Bank of Ukraine's (NBU) intervention to prevent an appreciation of the currency resultedin an over-run in its international reserves. The absence of measures to sterilize this increase in reserves

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led to the over-expansion of base money, fueling inflationary pressures. There was also an over-run inbanking system credit to non-government sector, which was partly due to efforts by the NBU through thebanking system to assist specific enterprises. Thus, to summarize, while there was a significanttightening of both fiscal and monetary policy in 1995 compared to the pre-reform period, there weresignificant slippages in both fiscal and monetary targets. Some of these slippages were the direct resultof attempts to bail out specific enterprises or specific sectors (e.g., coal industry) and contributed to laxfinancial discipline. These slippages not only jeopardized some of the macro-economic objectives, butby contributing to loose financial discipline they also undermined structural reforms and weakened thesupply response of the real economy. In early 1996, the government undertook corrective measures andtightened financial policies. The rate of inflation has come down markedly since, to 0.1 percent in June1996. Emboldened by this achievement, in September 1996 a new currency, the hrivnya was introduced.

15. Structural Reforms: The loan supported wide ranging reforms aimed at liberalizing the economyand promoting the private sector. Domestic trade and prices were to be liberalized, the foreign exchangeand trade regimes were to be opened up to market forces, and privatization of agriculture and industrywas to be accelerated. In these efforts too, the record was mixed. While major changes have been made,in many cases these fell far short of expectations.

16. Most prices were liberalized and limits on trade and profit margins lifted. Administered pricesfor utilities and communal services were significantly increased to recover costs. The multiple exchangerate system was abolished. Export quotas were eliminated, except for exports subject to VER and otherinternational agreements and for exports of grain. Imports remained free from quantitative restrictions,and the average import tariff remained low. These were major achievements for an economy mired inpervasive controls for decades, and in the midst of continuing economic decline.

17. However, various controls continue to operate. Indeed, in some cases, new interventions havereplaced controls that existed previously. Prior notification of price changes continued to be requiredfrom more than 16 categories of artificial monopolies, and local governments can regulate prices ofadditional "monopolies"2 Limits on profit and marketing margins for bread products remained in placefor most of 1995. While export quotas were eliminated for most commodities, other interventions weremaintained to control exports, such as the pre-export registration requirement and the system of"indicative" prices. Quotas were re-introduced in early 1995 on exports of ferrous and non-ferrous scrap,and grain producers suffered from quotas on their exports for most of 1995. In May 1996, export dutieson certain commodities were introduced. Exports under barter trade continued to be heavily taxed. Thesepolicy irregularities not only hurt economic recovery directly; they also undermined the confidence ofproducers and investors in the government's commitment to market reforms.

18. The most notable disappointment was in privatization, where the pace was much slower thanenvisaged under the loan. Only about a third of small enterprises had been privatized by the end of 1995compared to the expectation of 90 percent. Slippage was significant in the case of medium and largeenterprises also: compared to the goal of privatizing about 8000 enterprises by end of 1995 (out of a totalof 18,000), a majority of shares were sold to the private sector in only 1015 of these enterprises. ByMarch 1996, the number had risen to 1233. In agriculture, the amendments to the Land Code and thedraft Land Law that would have facilitated the development of a land market have yet to be passed byParliament, more than a year later than expected.

2 This was reduced to 9 categories in mid-1996.

19. There was also little progress in enforcing stricter financial discipline in enterprises. The budgetrenewed its subsidies to ailing industries, particularly to the coal sector. Commercial banks were alsoencouraged by the government to extend credits to the enterprise sector. And the government decidedthat the budget would continue to assume responsibility for. the gas debts accumulated by enterprises.Inter-enterprise arrears, including payment arrears, continued to grow strongly in real terms during theyear.3'

20. No comprehensive reforms were introduced to strengthen the social safety net, including old agepensions. The statistical and informational foundation for poverty analyses remains inadequate and theability to formulate social programs is limited.

21. To summarize, important gains were made during 1995-early 1996 in achieving macro-economicstabilization and in moving Ukraine toward a market-based economy. Most notably, the rate of inflationwas brought down and Ukraine was able to mobilize significant external financial assistance (includingrescheduling of its debts) from external creditors. The economy was considerably liberalized and firststeps were taken in privatization. However, implementation fell short of expectations, and in somecases, measures were taken that conflicted with the market-orientation of reforms. Moreover, the impactof these reforms, and their sustainability, are threatened by the slow progress in implementing reforms atthe enterprise and farm level. Privatization was much slower than projected in agriculture and industry,and financial discipline in enterprises remains weak. The social safety net is fragile.

D. MAJOR FACTORS AFFECTING PROJECT IMPLEMENTATION

22. An overwhelming factor that affected economic decision-making in all spheres was thecontinuing political struggle between those that favored reforms that those that opposed it. Deepdivisions continued to exist within the government and outside. For example, within the government,there was strong opposition from the Ministry of Trade to the liberalization of exports, and sectoralministries remained skeptical about reforms in agriculture and privatization in general. Opposition toreforms was also reflected in the continuing Parliamentary resistance to privatization and tax reforms4

and in constant pressure on the government to provide financial assistance to specific branches of theeconomy even if this jeopardized macroeconomic stability. The protracted confrontation between thePresident and Parliament regarding the division of powers between the executive and legislativebranches further delayed the implementation of key measures. Even when reforms were not completelyblocked, the constant opposition from large sections of the Parliament and vested interests (e.g., theagriculturists, coal miners) made the government unduly cautious and vulnerable to pressure. Thisfundamental problem also explains the constant irregularities in policy-making during the year. In thiscontext, it is all the more remarkable that some significant reforms were implemented, though it could beargued that this was possible largely due to external support (or pressure as some would call it),

3 Inter-enterprise arrears grew 240 percent in 1994 and another 128 percent in the first half of 1995.

4 For example, in October 1995 Parliament approved a law that required agro-industrial enterprises to be privatizedaccording to complicated, protracted procedures including a 12-month closed subscription period. The law also effectivelyguaranteed 51 percent of the shares of agro-industrial enterprises free of charge to agricultural suppliers, including stateand collective farms. With agroindustrial enterprises accounting for more than half of the enterprises targeted forprivatization in the first year of the project, the law would have been very damaging to the privatization efforts were it notvetoed by the President in December 1995. With respect to agricultural land, after much delay, amendments to the Landcode were accepted by the appropriate Parliamentary Commission, but they have not yet been passed by Parliament.

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including from the IMF and the Bank. Hopefully, the new Constitution, giving more powers to thePresident, will allow the government to implement reforms more aggressively.

23. Opposition to reforms was not always due to pressure from vested interests. Often it reflectedlegitimate concerns, and inadequate appreciation of the way markets work. Thus various restrictions onexports and on barter trade were imposed in part to prevent capital flight. Here the concern waslegitimate, the policy instrument inappropriate. Similarly quotas on grain exports partly reflected a lackof confidence in the ability of the private sector and market to allocate grain to shortage areas.Opposition to privatization partly reflected concerns that the process may be open to corruption.Practical problems also delayed implementation of some reforms.

24. A combination of these reasons affected the implementation of the privatization program whichwas far slower than envisaged during most of 1995. First, there was serious political opposition toprivatization, both for medium and large enterprises at the central level, and for small privatization insome local governments. Second, public awareness and interest in privatization grew only slowly, whichdelayed the sale of shares. Third, there were design flaws that were rectified during the course ofprivatization. For example, the minimum reservation price intended to prevent accusations of sellingenterprises too cheaply often turned out to be too high. Managers and workers did not have sufficientincentive to offer their enterprises for privatization. And finally there were institutional limitations suchas insufficient number of auctions centers. Some of these issues have since been addressed during thecourse of 1996.

25. Finally, there were factors that were beyond the government's control. Poor weather resulted inlower than projected levels of agricultural output in 1995. Output levels may also have been reduced bythe lower than expected level of disbursements from external donors (with the exception of the Bank andthe IMF). This shortfall in external financing also increased the reliance of the government on domesticborrowing and jeopardized the stabilization and liberalization objectives.

E. PROJECT SUSTAINABILITY

26. There is little doubt that significant reforms were implemented during 1995-96 that movedUkraine toward a market-based economy. There should be no doubt however that the entire reformprocess is still uncomfortably fragile, and can be reversed. The tightening of financial policies is puttingthe pressure on some important sectors (such as coal miners, the agrarian lobby) that has strong andvocal representation in Parliament, and opposition to reforms remains robust. On the other hand, there isas yet no visible or organized groundswell of support for reforms, and the safety net remains fragile.5

Unless there are tangible and visible benefits and sufficient number of clear winners, the risks of reversalare significant.

27. To prevent this, three things are important. First, the government must attempt, even moredeterminedly than before, to continue the course of reforms it has initiated. In particular, it needs tomove more quickly to complete the privatization of industry and agriculture, and to enforce financial

One reason for this could be that the very fact that existing controls were largely ineffective (as indicated by the growingunderground economy) meant that the immediate gains from liberalization were less manifest. Real benefits would onlybe evident when investment begins to recover and efficiency gains accrue. Both require a good track record ofmacroeconomic stabilization and private sector supporting policies.

discipline and commercial concerns in those enterprises that remain in state control. The energy sector isof special importance. No amount of market liberalization can generate a positive supply responseunless producers and investors have an incentive to react appropriately to market forces. At the sametime, the social safety net has to be strengthened to mitigate the effects of restructuring on the reallypoor. There can be no resumption of sustainable economic growth unless these reforms are accelerated.

28. Second, the international community must continue to actively support the government's efforts,at least until a strong domestic constituency in favor of reform emerges. This support must comprise notonly a large commitment of financial resources, but also technical assistance in providing short termadvice and in building long term institutional capacities in various areas of policy-design andimplementation. Careful and frequent monitoring of progress in all areas will also be necessary in orderto identify reversals and slippage and new approaches to solving emerging problems in implementation.Any setback to market reforms there is likely to have an adverse impact on Ukraine's transformation aswell.

F. BANK PERFORMANCE

29. In a sense, preparations for the Rehabilitation Loan began soon after Ukraine becameindependent. At that time, it was clear that significant policy-reforms would be required if Ukraine wasto overcome the crises caused by the break-up of the Soviet Union. Precious time was lost as thegovernment seemed unable to take the necessary steps to reverse the economic decline and it was onlyafter Mr. Kuchma's election as President in mid-1994 that the government finally indicated its resolve todeal with the deepening economic crisis. Throughout this period, the Bank and the IMF continued toengage in policy dialogue with the government both at the macro-economic level as well as in keysectors such as agriculture, energy, the enterprise sector, banking and the social sectors. Consequently,when the government indicated its resolve to tackle the crisis boldly, the Bank was well prepared torespond. A comprehensive policy package was developed and the loan was approved within 3 monthsfrom the time discussions were initiated. This quick response from the Bank, and the mobilization ofother external resources that followed the implementation of reforms the loan supported, not only helpedpay for critically needed energy supplies during the winter months, but also strengthened the hands ofreformers with the government and encouraged them to stay the course. In addition, the Bank's timelyresponse considerably enhanced its credibility within Ukraine.

30. The broad contours of the policy package seemed appropriate, even if there were weaknesses insome components. Its strength was that it tried to link the macro- or economy-wide aspects of reforms tothe micro- or sectoral reforms in an organic way. The idea was that without sectoral reforms, macro-economic stabilization policies would not be sustainable. Nor would any supply response beforthcoming unless structural reforms affected producers directly. Agriculture and energy wereespecially important. Thus, trade policy reforms emphasized the need to eliminate the quota on grainexports. Privatization of large enterprises included explicit targets for grain silos and warehousesnecessary for the development of markets in agriculture. The program to liberalize domestic tradefocused on reducing the scope of state trading in agricultural commodities, and in introducingcompetitive practices. And agricultural land privatization was a key consideration in the loan. Similarly,the loan focused on several of the most important issues in the energy sector, including pricing, arrears,and the development of a competitive wholesale market for electricity. Some of these issues had a directbearing on macroeconomic stabilization, apart from their financial and efficiency impact on the sectoritself. Reforms in these sectors, combined with measures to promote privatization and hard budget

-8 -

constraints in state enterprises, provided a good balance to the pure stabilization and liberalizationpolicies in the loan.

31. While the package may have been appropriate, it was flawed in some respects. First, the targetsand expectations were often too optimistic, both in relation to the past record as well as what was knownabout the government's implementation capacity. Despite skepticism, a judgment was made that in viewof the time already lost by Ukraine it was necessary to aim high, and that as implementation and otherconstraints emerged, targets would be suitably revised. This was factored in the design of the loan.6

32. While this flexibility was necessary, sometimes the large gap between targets and outcomes wasembarrassing and undermined the Bank's credibility. For example, under the Rehabilitation Loan allexport restrictions, except a specified few, were to be eliminated. Yet restrictions still remain. The sameis true for privatization in industry and agriculture.

33. Second, some of the proposed policy measures in the area of enterprise financial discipline werenot fully thought through. At one level, financial discipline was to be strengthened by maintaining tightcontrol on budgetary transfers and subsidized credits from the banking system. At another level, rapidprivatization was expected to take care of the problem. Yet there remained an anxiety that somethingmore direct had to be done, without quite knowing what. To satisfy the need for "something", it wasdecided that financial discipline would be enforced by: (i) picking a few large enterprises for closure,presumably to indicate the government's firmness; and (ii) identifying some large enterprises for whichrestructuring proposals would be developed and subsequently implemented. This "solution" was by nomeans unique to Ukraine; it had been tried elsewhere and there is no evidence that it had worked. It didnot work in Ukraine either.

34. The energy sector is especially vulnerable to payment indiscipline, which has seriousramifications for Ukraine's external creditworthiness. The Rehabilitation Loan required the governmentto establish a mechanism to ensure prompt payment to energy suppliers from budgetary organizationsand enterprises. However, no mechanism was developed, and the government continues to take periodicrecourse to ad-hoc decrees to force payments from defaulters. Given the important macro- and micro-impact of these problems, more thought is warranted to address this issue.

35. Supervision of the loan was adequate. A comprehensive review in March 1995 identifiedshortfalls in implementation, and after some corrective measures were taken, the second disbursementwas released in mid-May 1995. In addition to another supervision mission in June 1995, continuousmonitoring was done in the context of IMF missions and during the preparation of the Bank's EDAL andthe proposed AGSECAL. The Resident Missions of the Bank and the IMF were also very useful inkeeping a close eye on the status of implementation of the loan. Important slippages were identified andcontinuous pressure has been maintained to stay the course. However, it would be fair to say that it was

6 The Rehabilitation Loan to Ukraine was designed somewhat differently from the first Rehabilitation Loans in othercountries of the region. On the one hand, the government urgently needed foreign financing to purchase its energy importsduring late 1994 and early 1995. Yet, for practical reasons significant policy measures could not be implemented until thespring of 1995. To help the government pay for energy imports, and still maintain pressure on the government toimplement important policy reforms, the Rehabilitation Loan was disbursed in two parts. US$250 million were disbursedwhen the loan was approved (December 27, 1995) and the rest was disbursed in May 1996 after the Bank had satisfieditself that adequate progress continued to be made in implementing reforms. Unlike other adjustment loans, judgments onperformance were not tied to specific conditions.

- 9 -

largely the anticipation of new loans, or the threat of suspended disbursements, that led to correctivemeasures or a new round of reforms.

36. In retrospect it could be argued that the disbursements from the loan should have been stretchedout, at least till the third quarter of 1995, to maintain the pressure for reforms. This option was seriouslyconsidered, but rejected on the grounds that (a) it would not address Ukraine's immediate financingneeds and (b) subsequent fast disbursing operations would continue to provide ample leverage to theBank. The main issue is to what extent the Bank is prepared to go to enforce compliance with policycommitments.

G. BORROWER PERFORMANCE

37. Ukraine was a late starter in economic reforms. But it moved fast once Mr. Kuchma was electedPresident. Within a couple of months, a stabilization program had been agreed upon with the IMF,followed soon after with the comprehensive program of structural reforms supported by theRehabilitation Loan. A small but dedicated team of reformers spearheaded the Ukrainian effort, whichwas remarkable given the opposition of so many both within the government and outside. Toughmeasures were adopted, and the direction was set for the future. These efforts bore fruit and Ukrainereceived substantial external financial support.

38. However, there was and still is a sense that the reforms are not yet sufficiently internalized.Ukraine's financial position was critical and it badly needed external financing which was unlikely tomaterialize unless it had the support of the IMF and the Bank. Under this compulsion, policycommitments were made that were not sufficiently understood nor agreed upon by key members of thegovernment. This was true in several areas, but particularly true in foreign trade, agriculture, and socialsectors. In privatization too, there was serious disagreement within the government and it was by nomeans clear that agreement with the Bank had settled these issues. It was not surprising that seriousproblems arose when the measures had to be implemented. Either reforms were delayed, or in somecases steps were taken that violated the spirit of earlier reforms. Only the promise of new loans or thethreat of stopping disbursements triggered a fresh round of reforms. While the situation may beimproving, domestic support for reforms remains fragile, and continuing external financial and othersupport is necessary if the reform process is to be carried forward.

39. The institutional and technical capacity to implement reforms remains weak but is improving.There is no doubt that at least some of the delays in critical reforms could have been reduced ifimplementation capacity was better. This is as true of macroeconomics management as it is of sectoralreforms. There is also a need to improve policy coordination, not only to orchestrate the sequencing ofreforms in different areas, but also to avoid the issuance of government regulations and decrees that areinconsistent with the reform program. During 1995, this kind of coordination was only done prior toBank or Fund supervision missions; it needs to be institutionalized and adequately empowered.

H. ASSESSMENT OF OUTCOMES

40. The outcomes were more than satisfactory when compared to the economic situation existing atthe time the loan was approved. Inflation is down to low monthly rates, and the rate of decline in GDPhas been slowed down. Ukraine was also able to attract more than expected external capital flows and

- 10-

the pace at which external arrears was mounting has been reduced. The economy has been considerablyliberalized and the pace of privatization has picked up.

41. The outcomes are less satisfactory in two respects. First, by and large, results fell short ofexpectations. In some cases there were policy reversals. Second, and more important, the reformprocess remains fragile. Unless there is a long term but hard headed commitment from the Bank andIMF to continue to support reforms, it is still too early to rule out risks of reversal.

I. Future Operations

42. Recognizing the need for continuing balance of payment support to Ukraine and the importanceof deepening reforms in the real sectors of the economy, in particular in industry, agriculture and energy,the Bank moved quickly to design specific operations in these areas. Follow-up operations carriedforward the reforms initiated under the Rehabilitation Loan. In June 1996, the EDAL was approvedwhich accelerates privatization of small and large enterprises, and supports the growth of the capitalmarket and post-privatization restructuring of enterprises. An Agriculture Sector Adjustment Loan wasapproved in October 1996 that seeks to accelerate land reforms and private sector development. TheElectricity Market Development Loan aims to hasten the development of a competitive wholesale marketfor electricity. And the Coal Sector Adjustment Loan facilitates efficient restructuring in the coal sector.Other operations planned for the near future include a Pre-Export Guarantee Facility, an Urban TransportProject, and a Legal Reform Loan. Follow-up adjustment operations are proposed to support reforms inthe public sector and in the financial sector. The Bank will continue to chair the Consultative Groupmeetings.

J. KEY LESSONS LEARNED

43. The main lessons from the project are as follows:

(i) There is a strong tendency in the Bank to be over-optimistic about the outcomes ofadjustment operations, both in terms of macroeconomic objectives (reduction in inflation, growth ofGDP and exports) as well as structural changes (extent of privatization, demonopolization).

(ii) The opposition to market reforms is deeply entrenched. The Bank needs to decidewhether there is sufficient commitment within the country to warrant its continued involvement inreform efforts and then to stay engaged despite slippage and temporary reversals, which are inevitable.In practical terms, this requires identifying some key signposts that indicate the government'scommitment to reforms (such as macroeconomic stability and privatization) and to continue to supportthe government as long as these signs point in the right direction.

(iii) To the extent possible, the Bank should seek to involve in policy discussions those ingovernment who are skeptical about reforms, especially when they pertain to agriculture and the socialsectors. This may be time consuming and difficult, but ultimately beneficial.

(iv) Institutional capacity is limited, and very little can be done in the short time frame of anadjustment operation to change this. The Rehabilitation Loan had to be comprehensive in coveragebecause major distortions were everywhere and addressing one of them without the other would have

- Il -

failed. But subsequent operations should as far as possible be more narrowly focused. In this context,the shift towards sector adjustment operations is appropriate. The Bank should continue to assist thegovernment in developing its capacity to design and manage reforms, recognizing there is no quick andeasy fix.

(v) As in other parts of the region, the most difficult reforms to implement are those thatseek to enforce financial discipline in enterprises and farms, and make them more responsive to marketforces. Yet these are the most critical areas, especially when markets have been significantly liberalized.Apart from privatization in industry and agriculture, some of the other measures in this area include thecontinued brake on budget transfers and credit subsidies to specific sectors and enterprises, prevention ofaccumulation of payment and tax arrears, and measures to facilitate new entrants and the closure ofunviable firms.

(vi) There is often a tendency to do something more about enterprises that will notimmediately be privatized. Typically, this takes the form of closing down a few large unviableenterprises, and requiring restructuring plans to be developed for some other enterprises. Quite apartfrom the fact that it is often hard to assess what are viable activities and what are not given all thedifferent distortions and accounting issues, there is little evidence that these measures have contributed toany lasting solution. Yet they persist in the Bank's 'conditionality' repertoire, to the aggravation of thegovernment prior to implementation and to Bank's staff thereafter. Unless there is a very clear conceptbehind these kinds of solutions, and a long term commitment from the Bank to remain closely involvedat all stages of the effort, these interventions should be avoided.

(vii) Policy conditionality should be designed to be as 'close' as possible to the specificobjective that is to be achieved. Thus for example, conditions such as "presentation of draft law toParliament .." should be avoided because (a) legislation may not be really required (as in the case ofprocedures for land registration in Ukraine) and (b) there is a big gap between presentation of law and itsapproval by Parliament, let alone the implementation of the policy.

(viii) Given the uncertain political support for reforms, the limited institutional capacity andthe uncertainties of predicting the nature and size of supply response, it would be prudent to maintainrealistic expectations and to be flexible in response to slippages in policy and projected outcomes. Thephased disbursement design of the Ukraine Rehabilitation Loan was a useful innovation in this regard.

(ix) Intensive monitoring and supervision by the Government and the Bank is essentialduring the early years of reform when slippages may occur not just because there is active opposition butmerely because of misunderstanding about what needed to be done or insufficient manpower. Anadequately staffed Resident Mission can play an invaluable role in this respect.

(x) A suitably empowered authority within the Government to coordinate and overseeprogress in reforms is vital not only for the indigenous development of the reform program, but also toprevent implementation of sectoral policies that go against the spirit of the economy-wide reforms.

- 12 -

Part II. Statistical Tables

Table 1: Summary of AssessmentTable 2: Related Bank Loans/CreditsTable 3: Project TimetableTable 4: Loan/Credit Disbursements: Cumulative Estimated and ActualTable 5: Key Indicators for Project ImplementationTable 6: Key Indicators for Project OperationTable 7: Studies Included in ProjectTable 8A: Project CostsTable 8B: Project FinancingTable 9: Economic Costs and BenefitsTable 10: Status of Legal CovenantsTable 11: Compliance with Operational Manual StatementsTable 12: Bank Resources: Staff InputsTable 13: Bank Resources: Missions

13

Table 1: Summary of Assessments

A. Achievement of Objectives Substantial Partial Naligib Not applicable

Macro Policies C0

Sector Policies C C C

Financial Objectives a [ C C

Institutional Development [ (0C

Physical Objectives C C C E

Poverty Reduction a C [ 0

Gender Issues lEl [El

Other Social Objectives C C C [lEnvironmental Objectives C C 0

Public Sector Management C [El El C

Private Sector Development C I. C Cl

Other (specify) E C C C

(Continued)

14

B. Project Sustainability Likely Unlikely Uncrtain

C. Bank Performance satisfacto Satisfactory Deficient

Identification [i E 1

Preparation Assistance l a l

Appraisal El E Supervision i:i

D. Borrower Perfonnance satsfa= Satisfactorv Deficient

Preparation n I3 oImplementation a E 3oCovenant Compliance ] El

Operation (if applicable) E l E

HigIh& kLlE. Assessment of Outcome satisfaty Satisfactor Unsatis by unsatisfactory

) ) (/)

El l E

15

Table 2: IBRD Loans

Loan/Credit Title Purpose Year of Approval Status

Preceding Operations

1. Institution Building Loan Institution Building FY93 Under implementation

Following Operations

1. Hydropower Rehab Energy rehabilitation FY95 Under implementation

2. Agricultural Seed Develop Specific investment loan FY95 Under implementation

3. Housing Foster growth of the FY96 Signed 12/19/96housing market Not yet effective

4. Coal Pilot Restructuring of the coal FY96 Under implementationindustry

5. Enterprise Develop Adjust Support acceleration of FY96 Under implementationenterprise privatization

6. Social Protection Support Support the move toward FY97 Signed 12/19/96targeting of social assistance Not yet efffective

7. Electricity Market Develop Support the development FY97 Under implementationof a competitive electricitymarket

8. Agriculture Sector Adjust Support acceleration of FY97 Under implementationland reforms and privatesector development

9. Export Development Specific investment loan FY97 Approved 11/21/96Not yet signed

10. Coal Sector Adjust Facilitates efficient FY97 Under implementationrestructuring in the coalsector

16

Table 3: Project Timetable

Steps in Project Cycle Date planned Date actual/latest estimate

Identification (Executive Project Summary)

Preparation N/A 9/94

Appraisal N/A N/A

Post appraisal N/A N/A

Negotiations 9/93 11/94

Letter of development policy/MERP 9/93 11/94

Board presentation 12/94 12/94

Signing 12/94 12/94

Effectiveness 12/94 12/94

First tranche release N/A N/A

Midterm review N/A N/A

Second (and third) tranche release N/A N/A

Project completion 6/96 6/96

Loan closing 6/96 6/96

17

Table 4: Loan Disbursements: Cumulative Estimated and Actual(US$ thousands)

FY95 FY96

Appraisal estimate 362.4 137.6

Actual 364.16 135.84

Actual as % of estimate 101% 99%

Date of final disbursement N/A 5/31/96

0-

Table 5: Key Indicators for Project Implementation

UKRAINEREHABILITATION LOAN

STATUS OF MEASURES UNDERTAKEN

IMPLEMENTATION RECORD

I. MACROECONOMIC STABILIZATION1. Agreement with IMF on standby arrangement. A standby arrangement was agreed upon in April 1995. Initial results of the program were encouraging; inflation2. Satisfactory implementation of macroeconomic stabilization policies. fell to monthly rates of around 5% in April-August 1995, from 28% in December 1994. However, the second half

of 1995 witnessed delays and slippages, and the targets of the Standby Arrangement were not achieved. Correctivemeasures were adopted in early 1996 and a rephasing of the Standby Arrangement was agreed upon between theGovernment and the IMF. Performance criteria and indicative targets are currently being met. Inflation hasdropped to 0.1 % in June 1996.

1. Sharply reduce numbers of artificial monopolies subject to price "Artificial monopolies" subject to price regulation were not reduced, merely rearranged into 16 broadly definedregulation (by January 1, 1995). categories. In addition, oblasts have the authority to regulate additional items of "monopolies". There exists a large

Price Inspection Unit to enforce price controls.2. At retail level, maintain price controls only for public utilities, publictransportation, fuel for households, and rents.

3. Eliminate limits on profit margins for crude oil and oil products (as of Eliminated as of December 1994.January 1, 1995).

4. Periodically adjust natural gas prices for industrial, agricultural and As of December 1994, industrial and agricultural users pay the full cost of imported gas.governmental organizations to cover import, domestic contribution.

5. Liberalize wholesale electricity prices by end of 1995 when competitivemarket is established.

6. Establish competitive wholesale market for electricity by end of 1995.

7. Liberalize coal prices, except for household use by January 1, 1995. Price raised to world equivalent levels in January 1995, but not liberalized by end of 1995.

8. Increase electricity prices for households to achieve 40% cost recovery Electricity charges for households was increased in March 1995 to achieve 8O0/. of cost recovery. However, certainby January It, 1995 and 60% by June 1995. groups of households remain entitled to substantial discounts. As of mid-1995, the average household electricity

price recovers about 50% of cost.

9. Increase prices of other household public utilities and rents substantially Prices of transportation, coal and gas to households were raised in February 1995 to achieve cost recovery of atin January and June 1995. least 400/o. Housing rents and charges for communal services were raised to achieve 30%i/o cost recovery on June 1,

1995 (from 20% in February 1995).

10. Liberalize bread prices by January 1, 1995. Eliminate profit margin Not done. Bread prices were raised in October 1994 but subsequent increases were less than the rate of inflation.ceilings on bread and bread products, baby food and flour as of January 1, Bread and most bread products remained subject to maximum profit and marketing margins.1995.

1. Abolish existing trade system of state orders, including grains, by System of state orders was abolished. However, procurement of grain was significantly larger than necessary forJanuary 1, 1995. Limit state procurement to goods necessary for budgeting budgetary organizations. Significant part of government procurement still not done on basis of competitiveorganizations and adopt open bids and tenders for this process. mechanisms (e.g., more than half of procurement of agricultural commodities is not done through commodity

exchange or other competitive tender mechanisms.

I. Progressively open inter-bank market for foreign exchange to all The participation of licensed banks has increased and rules goveming membership in the inter-bank market allowlicensed banks. for new participants.

2. Eliminate all export quotas and licenses by January 1, 1995 except the All export quotas for (1) goods subject to VER and other international agreements, and (2) grain were eliminated ingoods subject to VER and other international contingent agreements. early 1995. All export quotas except for (1) goods subject to VER and other international agreements and (2) grain

were eliminated in early 1995. Export registration requirements were also abolished except for exports underinternational agreement and to prevent anti-dumping action. However, a system of "indicative export prices" wasintroduced to control exports. Quotas on the export of grain were eliminated in February 1996.

3. Lower maximum import tariffs to 30% by January 1, 1995 and further by Imports with tariffs above 30%/o estimated to be 0.7% of total imports in 1994. No further reductions in tariffs inend of 1996. If tariffs were raised above the maximum rate temporarily, the 1995.cumulative share of goods with such tariffs in total imports in 1993 couldnot exceed 1%.

4. Unify excise duties on imported and domestically priced goods by March1995.

5. No QRs to be imposed on imports. Imports remain free of QRs.I-

1 Complete privatization of 900/o of small enterprises by end of 1995. Only 290/ of 45000 small enterprises privatized by end of third quarter of 1995.

2. Distribute paper certificates in 5 oblasts by December 15, 1994. Implemented. Paper certificates were made available in all oblasts in February 1995, though as of mid-1995, only12% of the certificates had actually been collected by citizens. By mid-April 1996, over 2/3 of the population hadeither collected their certificates or opened privatization accounts with the Savings Bank.

3. Complete stock auctions (including tirucking and warehousing) in 5oblasts for at least 200 medium to large enterprises using simplifiedprocedures by March 15, 1995.

4. Privatize some grain silos.

5. Extend stock auctions to the entire country by April 1995.

6. Auction at least 1000 medium and large enterprises between January- Since the first pilot auctions in February 1995, about 400 medium and large enterprises were privatized usingJune 15, 1995. vouchers by end of 1995.

7. Complete sale of shares by public auction of at least 8000 medium and In 1995, majority of shares sold in the private sector in only 1015 of the 8000 enterprises. By March 1996, thislarge enterprises by end of 1995. number had increased to 1233.

8. Present to Parliament appropriate amendments to the Land Code by Not done. Expected to be done prior to release of second tranche of AGSECAL, expected before December 31,January 1, 1995. 1997.

9. Present to Parliament a draft law on registration of land and other real Not done. Expected to be done prior to release of second tranche of AGSECAL, expected before December 31,estate specifying procedures for registering land and real estate by January 1997.1, 1995.

1. Implement restructuring plans in 20 large enterprises, including partial orfull privatization, partial or full closure, divestment of assets, etc.

2. Close down some large non-viable state enterprises. Ministerial orders were issued for the closure of 24 coal mines in 1995. As of mid-1995, coal production hadalready been stopped in 8 mines, and labor force reduced by 6000.

1. Eliminate credit ceilings on banks and shift to market oriented measures Individual credit ceilings on banks were eliminated and refnance credit of the NBU is allocated by credit auctionsof monetary policy by early 1995. at market interest rates. However, new programs of directed credit, aimed at selected enterprises were implemented

in 1995 and refinance credits were targeted to specific enterprises.

2. Complete study defining, evaluating and costing alternative restructuringplans for former state bonds by March 15, 1995.

3. Develop concrete restructuring proposals by mid-June 1995 forimplementation later in the year.

1. Complete policy papers on social assistance and on pensions andunemployment compensation by mid-March 1995.

2. Begin implementation of comprehensive reforms by end of 1995.

3. Initiate integrated household survey to most needy families, and A scheme of income based targeted subsidy was implemented effective May 1, 1995. This scheme providedimplement improved targeting scheme based on survey results. income support to households in which the housing and energy bill exceeded 15% of its total income.

4. Protect pension of low income pensioners.

5. Initiate measures to strengthen the pension system over the longer term,e.g., by raising retirement age and by discouraging pensions for activeworkers.

6. Based on study, implement comprehensive reforms in unemployedcompensation scheme.

7. Review expenditures of social insurance.

8. Initiate means to eliminate propuska.

22

Table 6: Key Indicators for Project Operation

Estimated Actual

1. Key operating indicators in SAR )

11. Modified indicators (if applicable) ) - NOT APPLICABLE -

111. Modified indicators for future Joperation (if applicable) )

23

Table 7: Studies Included in Project

Study Purpose as defined Status Impact of studyat appraisal/redefined

- NOT APPLICABLE -

24

Table BA: Project Costs

Appraisal estimate Actual/latest estimates(US$ million) (US$ million)

Item Local Foreign Total Local Foreign Totalcosts costs costs costs

1. Import 0.0 660.0 660.0 0.0 660.0 660.0

Total 660.0 660.0 0.0 660.0 660.0

25

Table 8B: Project Financing

Appraisal estimate Actual/latest estimates(US$ million) (US$ million)

Source Local Foreign Total Local Foreign Totalcosts costs costs costs

1. IBRD/IDA 0.0 500.0 500.0 0.0 500.0 500.0

2. Cofinancing institutions 0.0 160.0 160.0 0.0 160.0 160.0

3. Other external sources 0.0 0.0 0.0 0.0 00.0 00.0

4. Domestic contribution 0.0 0.0 0.0 0.0 00.0 00.0

* Canada $1OmJEXIM $150m

26

Table 9: Economic Costs and Benefits

- not applicable -

27

Table 10: Status of Legal Covenants

Original RevisedAgreement Section Covenant Status Fulfillment Fulfillment Description of Covenant Comments

Type Date DateLA 3.01 (a) 9 C --- --- Consultation and exchange

of views

LA 3.01(b)(c) 9 Progress report to be submitted tothe Bank

LA 3.02 9 C --- --- Procurement schedule

LA 3.03 3 C --- --- Local currency transactionsto be made at MarketExchange Rate

LA 3.04 5 C --- --- Maintain Project Manager and staff

LA 3.05 5 C --- --- Maintain staffed inter-agencycommittee responsible formonitoring and coordinatingProgram implementation.

LA 3.06(a)(c) 1 C --- --- Maintain records andaccounts.

Covnenat type: Present Status

1 = Accounts/audits 8 = Indigenous people C = covenant complied with2 = Financial performance/revenue 9 = Monitoring CD = complied with after delay

generation from beneficiaries 10 = Project implementation not covered by CP = complied with partially3 - Flow and utilization of project funds categories 1 - 9 NC = not complied with4 - Counterpart funding 11 = Remedies

5 = Management aspects of the project or 1 2 = Sectoral or cross-sectoral budgetary orexecuting agency other resource allocation

6 = Environmental covenants 13 = Other7 - Involuntary resettlement

28

Table 11: Compliance with Operational Manual Statements

Statement Number and Title Describe and comment on lack of compliance

- NOT APPLICABLE -

I

29

Table 12: Bank Resources: Staff Inputs(5'000)

Planned Revised ActualStage of project cycle Weeks USSs Weeks US$s Weeks US$s

Preparation to appraisal 10.0 35.6 42.4 164.2 76.8 239.7

Appraisal 0.0 0.0 12.3 23.6 12.3 23.1

Negotiations through 0.0 0.0 20.2 39.9 20.2 29.8Board approval

Supervision 20.0 57.6 47.6 185.2 50.3 214.6

Completion 10.0 34.0 2.8 15.0 2.8 15.0

30

Table 13: Bank Resouces: Missions

Performance Rating 2No. of Days in Implementation Development Types of 3

Status of project cycle Month/Year Persons Field Specialization Status Objectives Problems

Preparation 08/94 7 14 E,F,A,O

Appraisal through 06/93 13 25 E,F,A,OBoard approval

Supervision 12/93 3 10 E,O04/95 7 8 E,O08/95 7 8 0

Completion

1 - Specialization 2 - Performance Rating 3 - Types of Problems

A = Agriculturalist 1 = Minor problems F = FinancialE = Economist 2 = Moderate problems T = Technical

F = Financial Analyst 3 = Major problems M = Managerial

' Other includes country officer, operations analyst, sector specialist,procurement and disbursement specialists. Many of the specialistsvisited the country in combination with other missions.

31

NATIONAL AGENCY OF UKRAINE FOR RECONSTRUCTION ANDDEVELOPMENT

Mr. Sergiy KulykAlternate Executive Director

Conclusion on RehabilitationLoan Implementation(Loan No. 383 1-UA

Rehabilitation Loan of the World Bank was aimed to support restructuring,macroeconomic stabilization of economy, renewal of economic growth anddevelopment. It was not possible to achieve the above mentioned goals at the expenseof own financing. This is why implementation of the Rehabilitation Loan was veryimportant and timely. The project has considerably facilitated implementation of mostof positive changes.

Ukraine economic program focuses on the following mutually interdependentelements. Firstly, macroeconomic stabilization is based upon financial and monetaryrestrictions, supported by the corresponding taxation policy. Secondly, measuresaimed at promoting competition at the commodity and services markets envisageactions along several strategic lines, such as for example liberalization of prices on theinternal market as well as foreign trade regime and currency exchange, discontinuationof the state orders system and liberalization of internal trade. Thirdly, it is envisagedthat commencing of privatization process, application of liquidation procedures andregulations on bankruptcy and revision of methods of enterprise management will leadto introduction of stricter budget restrictions for enterprises. Corresponding financialpolicy (including discontinuation of target crediting, introduction of realistic positiveinterest rates and implementation of measures to strengthen payment discipline) andalso reformation of financial sector will facilitate introduction of changes envisaged bythe program at the level of separate enterprises.

With the purpose to ensure stable reduction of inflation rate, Ukraineintroduced stringent financial and monetary policy in order to prevent transformationof price rise, connected with liberalization of prices on the internal market andunification of exchange rates into inflation as well as to achieve desired goal:

32

balanced budget. Public expenditures have been considerably reduced, includingsubsidies for bread and coal, housing and municipal services as well as agriculturalsector subsidies.

The general aim in the sphere of pricing policy was considerable limitation ofthe state interference ( at the level of central Cabinet of Ministers as well as at the levelof local power bodies) into the process of prices formation and regulation. This isconducive not only to more effective distribution of resources, energy carriers inparticular, which are in constant shortage and which are exported from abroad and alsoconsolidation of the state budget. The Cabinet of Ministers has cut most ways to ofthe state interference into price formation process, including direct control over prices,income restrictions, fixed upper limit on retail trade surcharge at the state and locallevels and also informing local bodies of power and getting their approval to changeprices for particular goods and services.

At the industrial level the state control over prices remained only for thosegoods and services, where monopoly position of the manufacturer has naturalcharacter (power, gas, central heating, water supply and sewage, public transport andpremises rent) as well as for the few remaining artificial monopolies, the number ofwhich is reducing.

The Cabinet of Ministers of Ukraine made decisive steps towards accelerationof the private sector development and its integration into normal economic processesand have removed main obstacles on this way. Firstly, procedures of registration ofnew businesses was simplified and the term of its consideration by the local bodies ofpower was reduced. Access was opened to all spheres of economic activity, includingtransport services and distribution of goods. Secondly, with accelerated tempo ofprivatization, an access to means of production was facilitated, because stricter budgetlimitations for state enterprises make the latter either to sell or to lease real estate andother property. State enterprises are allowed to sell their property of the value below2000 minimal wages by open competitive sale. Thirdly, the Cabinet of Ministersdeveloped new taxation system in order to reduce the burden of taxes on economicactivity and completely do away with discrimination of the private sector where suchdiscrimination exists.

In order to promote export and open Ukraine economy for international tradeand competition the Cabinet of Ministers implemented decisive steps in the sphere ofreforming foreign trade regime. On October 5, 1994 operations were resumed atinterbank currency exchanges. Official rate for forced turning in of currency waseliminated in October 26, exchange rate was unified and at present it is determined atinterbank auctions. All licensed banks are eligible to participate in currency tenders,exchange rate is determined and their applications are processed without interferenceof administrative bodies. Distribution of hard currency through Tender Committee

33

was abolished. Current accounts in KBV high level of convertibility was resumedwith full convertibility for all trade and accompanying operations.

The Cabinet of Ministers has also implemented measures to liberalize foreigntrade. All export quotas and licenses were abolished excluding only those which aresubject to voluntary export restrictions. With unification of exchange rate andabolition of export quotas there disappeared the need in price indices, which were usedfor control and regulation of export. Price indices are issued only to ensure supply ofinformation to exporters; customs service received instructions to stop their usage forregulation of export.

As far as import is concerned, the state does not implement quantitativelimitations excluding licenses, which at present are applied to norms of health care andsafety measures. The system of tariffs for import was modified towards introductionof low and unified rates. It was achieved by means of reducing maximum tariff rateby 20 per cent. Ukraine will try to avoid frequent revision of the system of tariffs.

During the process of preparation and implementation of the Project theCabinet of Ministers of Ukraine efficiently collaborated with the World Bank bymaintaining constant relations and working with World Bank missions. Generally,joint work with the World Bank has considerably facilitated and improved relationsbetween Ukraine and other financial donors.

Sincerely,

Deputy Chairperson of the National Agency T. Solianyk

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Report No.: 16334Type: ICR